Non-Traded REITS: A Fool and His Money

As the Fed continues sucking yield out of the marketplace, individual investors are desperate for return.  This has fueled a moon-shot in a host of dicey instruments sold only on the basis of percentage returns. 

 

Hedgeye energy analyst Kevin Kaiser has written extensively on oil and gas Master Limited Partnerships, many of which are purely accounting exercises designed to lure investor money to pay management compensation.

Non-Traded REITS: A Fool and His Money - Atlas cartoon

Oil and gas aren’t the only sure thing in America today.  There’s also real estate, available in “non-traded REITS.”  These are illiquid private investments.  Since the function of the marketplace is price discovery, where real transactions establish a real-time market price, how does your brokerage firm price non-traded instruments on your statement?

 

Simple.  All non-traded REITs are priced $10 a unit, regardless of the value of the underlying portfolio.  Non-traded REITs are sold to the investor at $10 a share, and FINRA permits them to remain on brokerage statements at original sale price.   Since REITs are very long-term instruments, it will be a long time before the investors find out the actual value of their holdings – typically, only when the REIT goes bust because there is no residual value to the properties.

 

Non-traded REITS are marketed as being “stable” – because they’re not subject to market price fluctuations – and have become increasingly popular as investors grow desperate in a world without yield.

 

Even if they’re not so great for you, they are a great deal for the firms that sell them.

 

A typical non-traded REIT can pay a 7% sales commission, plus a 2.5% “dealer management fee” and 3% in offering expenses – all taken off the top.  You end up with 87.5 cents of every dollar actually invested: your REIT has to appreciate 14% in value before you are even.

 

The REIT managers also pay themselves ongoing fees.  One real-world example had managers taking a 4.5% annual management fee, plus 3% for leasing properties.

 

But wait – there’s more.  Because they are often blind pools, the REIT managers don’t buy real estate until all the money is in (there appears to be no rule barring managers from selling their own operating properties to the REIT they manage, a massive self-dealing loophole.)

 

During the process of acquiring the properties for the REIT, they make regular payments to the investors.  These payments are non-taxable (great!) because, since there are no operating properties in the portfolio, they’re just giving you back your own cash (oh… not so great).  And recording it as yield (how’s that?!)

 

In 2011 industry oversight body FINRA proposed a rule requiring disclosure of the actual value of these investments.  This month, over 2 ½ years later, FINRA says they aren’t ready to send the rule proposal to the SEC.  They are still mulling over the comments they received.

 

The comments appear to be overwhelmingly objections from the firms who market these instruments.  As with many other public comment exercises, if you want to know what the average retail investor thinks of non-traded REITS, don’t ask FINRA.  They don’t know.

 

As sales of these instruments swelled to $20 billion in 2013, the best FINRA could do was to issue Investor Guidance (Public Non-Traded REITs—Perform a Careful Review Before Investing)

 

The fecklessness of FINRA and its efforts at investor protection goes a long way towards explaining the explosion in these types of investments.  “You gonna listen to the regulators?!” says the salesman.  “They don’t know the first thing about the markets!”  While we generally can’t argue with that proposition, it does not logically follow that one is better off embracing the advice of a salesman who won’t tell you how much he’s getting paid on the transaction (if you ask, he is required by law to give you a full description of commissions, fees and charges.)

 

The Fed’s prolonged QE program is intended to boost asset prices, raising the price of securities by creating dollar inflation and praying that wealth will magically “trickle down” throughout the economy, a fairy tale Washington and Wall Street have been telling us for two generations. 

 

The Fed hasn’t learned two basic lessons of finance: the money business brings out the worst in people; and what goes around, comes around.  You can’t inflate forever.

 

Legendary former Bear Stearns head Ace Greenberg warned in the early stages of the 1980’s bull market that growth in the financial sector would attract criminals and scam artists in their legions.  While Ace was slugging it out in the trenches, Bernanke and Yellen were assiduously taking notes in their advanced Econ seminars. 

 

If you want to know why the store is in such rotten shape, you need only look at who’s minding it.


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